Stock market darling Datalex triggers €30m headache for Dermot Desmond

Before its shock profit warning earlier this week, travel software group Datalex largely flew under the radar on the Irish stock market – even as its meteoric 960 per cent share price surge in the past decade beat the Iseq by seven and a half times.

As one of the Iseq's four top performers during the period, billionaire financier Dermot Desmond was the main beneficiary as his IIU investment firm's interest inched higher to 26.4 per cent.

Almost €30 million was wiped off the value of that holding on Tuesday, however, as Datalex slumped 59 per cent after warning that it faces up to a $4 million (€3.5 million) loss for 2018, compared to market expectations for an almost $20 million profit.

Optimism

Sources said the warning stems from Datalex’s optimism on its ability to deliver, on time and on budget, its biggest project to date – an overhaul of German carrier Lufthansa’s digital commerce offering.

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When it came to trying to recoup the cost overruns from Lufthansa, it became apparent the contract was much more favourable to Europe's biggest airline than the Irish tech minnow.

Datalex remains in talks with the carrier but it’s highly likely the shortfall will end up being written off. The company highlighted in its statement that it was sitting on $8.8 million (€7.7 million) of cash at the end of year – almost half the level of a year earlier and well off the $24.4 million in its coffers at the end of 2016.

Datalex fought hard to get the Lufthansa project, so it could pitch for other mega contracts. Will this week's news put off other potential partners?

When the issues emerged is not entirely clear. The company, led by chief executive Aidan Brogan, issued an upbeat trading update in late November, saying it had been performing in line with expectations and was "confident" about delivering double-digit percentage earnings growth for the full year.

With Datalex refusing to provide any further details beyond the sparse stock exchange announcement this week, a key concern for investors must be whether the cash position will be hit as it is forced to pay groups it has outsourced Lufthansa work to - at a time when it is questionable how much it can recoup.

Deal

While the company, which signed the Lufthansa deal in the second half of 2016, originally expected to complete the project early last year, sources have said that it will be next month before the first of three phases goes live.

Datalex also revealed on Tuesday that it may have mis-stated revenues and earnings for the first half of last year, mainly due to the “accelerated recognition” of income associated with its biggest customer. This is a tricky business at best in the software industry. Being too aggressive in booking revenues for uncompleted work tends to have consequences.

It’s clear from looking at Datalex’s recent annual reports that its external auditors had been alive to the risks as they challenged management. EY warned in the 2017 report that “there was a heightened degree of subjectivity applied by management” as it calculated how much revenues it could book on unfinished projects, based on estimates of how advanced they were.

Before that, Datalex's previous long-time auditor, PwC Ireland, highlighted that the company had to "exercise significant judgment" in assessing what percentage of the total work had been done when it came to booking revenues for 2016. PwC has now been hired to look into the possible mis-stated figures last year.

Pressure

The problems are bound to trigger investor pressure to overhaul Datalex's board. Aside from IIU's 26.4 per cent, two hedge funds - Chicago-based Kabouter Management and Highclere International in London - own 14.4 per cent between them.

They may have taken a relaxed view even as major corporate governance advisers, such as Institutional Shareholder Services (ISS) and Glass Lewis, highlighted concerns in recent years.

ISS and Glass Lewis urged investors to vote against the reappointment of long-time non-executive directors, IIU's representative John Bateson, and Peter Lennon, at last year's annual general meeting saying they couldn't be considered independent, as Datalex had classified them.

Long tipped by analysts as a takeover target, this episode could kill off a potential exit strategy for Desmond's IIU and hedge funds.

ISS said Datalex’s audit committee was not compliant with the advisory firm’s policy of only consisting of independent non-executives. Bateson is the chairman and Lennon a member of this key committee. Less than 20 per cent of voters at the AGM heeded the proxy advisory firms’ recommendations.

Capitalisation

EY and PwC had highlighted in their auditors reports in the past two years how the company’s management relied on a high degree of judgement and estimation when determining how much of its project development spend could be “capitalised” – or added to its asset base.

R&D capitalisation is another highly complex and debated area for software companies. The more development spend that can be capitalised, the less that needs to be written off and charged against profits.

You can see why industry executives, keen to show earnings growth, argue that as much as possible of R&D spend on software is about building long-term assets, rather than just another cost of doing business. Datalex’s capitalised development spend rose 40 per cent in 2017 to $13.1 million.

Datalex fought hard to get the Lufthansa project, so it could pitch for other mega contracts. Will this week’s news put off other potential partners? Or lead staff-retention issues at a time there is already a competitive market for tech skills in Dublin?

Long tipped by analysts as a takeover target, this episode could kill off a potential exit strategy for Desmond’s IIU and hedge funds. Or, it could lure an opportunistic suitor, attracted by the share price slump. Time will tell.