Empired Ltd falls even as profit doubles: Is the stock a buy?

Empired Ltd (ASX:EPD) crashed 10% as its cash flow chokes under the weight of a recent acquisition. But is this a buying opportunity given management’s promise of robust growth this and next year along with higher dividends?

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Information technology services firm Empired Ltd (ASX: EPD) won’t be joining its peers at the post-results season party with the stock crashing 11% in afternoon trade despite delivering a strong result and outlook.

The stock’s tumble to a one-week low of 68 cents must be frustrating for shareholders given that management has posted a 74% surge in revenue to $50.5 million for the six months to end December 2014 and a dramatic turnaround in net profit to the tune of $1.2 million, compared with a loss of $36.9 million in the first half of the previous financial year.

Others in the sector, such as SMS Management & Technology Limited (ASX: SMX) and Data#3 Limited (ASX: DTL) have run up strongly after releasing their results, and there’s growing confidence that the IT spending drought could finally be coming to an end in Australia.

It isn’t an uncertain outlook that is causing pain for Empired either. Management has not only given full year revenue guidance for 2014-15 but has stuck its neck out even further by stating a 2015-16 target.

Empired said it is on track to deliver group sales at the upper end of its $110 million to $120 million forecast for the current financial year and is tipping a topline of $145 million to $165 million for the following year.

So why isn’t this enough to keep investors happy?

Perhaps there is some disappointment that Empired didn’t lift its 1 cent a share interim dividend given the very robust surge in profits (although it is promising an increase to full year distributions), but it’s more likely the sharp deterioration in cash flows that is spooking the market and sparking concern that management may have bitten off more than it can chew with its recent $17.4 million acquisition of Intergen Ltd.

In spite of the 236% increase in first half earnings before interest, tax, depreciation and amortisation (EBITDA), the company recorded a net operating cash outflow of $3.7 million, which is nearly five times worse than the same period last year.

Management has tried to assure investors that this is no more than a one-off issue that’s related to the acquisition of Intergen. About $1.8 million was deducted for transaction costs and there was a $2 million increase in working capital due to two large fixed cost projects.

Then there’s IT issues causing invoicing delays. Oops! Did an IT company just say it was having IT issues?

There’s also the difference between receivables and payables widening to $13 million for the period (this blowout increases working capital requirements), although management claims the invoicing problem has been rectified and that it was expecting positive cash flow in the second half.

Assuming management is right about its cash flow issues being a temporary hiccup, the share price drop could seem like an overreaction.

However, the issue is Empired is trading on a 2014-15 estimated price earnings multiple that is well in excess of 20x.

It is not unusual for high growth stocks to trade at such a premium. But to earn this premium, there cannot be any doubt about the quality and outlook of the company.

Empired has introduced doubt and that’s why it is being punished.

However, I am still prepared to give management the benefit of the doubt. The risk-reward ratio also supports my view that the correction in the share price is temporary.

For that perspective, the weakness should be seen as a buying opportunity. Fingers crossed that management can deliver on its promises for the current half.

Motley Fool contributor Brendon Lau owns shares in Empired.

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