Why have shares in Redcentric plc crashed by two-thirds today?

There are small accounting issues and then there are big ones. Today’s surprise announcement from IT services provider Redcentric (LSE: RCN) falls firmly under the latter heading, which is why shares fell by more than 60% in early trading.

The company shocked the market this morning by disclosing that a routine re-examination of the books prior to releasing interim results had “discovered mis-stated accounting balances in the group’s balance sheet.” Management went on to say “correcting these cumulative historic accounting mis-statements would result in a need to reduce net assets by at least £10m.” This is a major setback for a company that recorded £90.8m of net assets on the balance sheet at the end of the latest reporting period.

How deep do these problems stretch? Evidently the problems reach back over several years and were bad enough that the CFO was sacked on Sunday. Furthermore, management also revealed that writedowns to previous profits are likely and that net debt was materially higher than reported to the market.

The one figure included in the announcement was that management “believes net debt at the half year was approximately £30m.” This should worry investors for two reasons. One, net debt at the end of the latest fiscal year ending March 31 was initially reported as £25.3m. So, if it was reduced to £30m by the end of September then management isn’t exaggerating by saying the true figure was “materially” higher than reported.

The second cause for concern is the use of the word ‘believe’, as it illustrates the fact that the company is in the midst of its forensic accounting review and further problems could be announced. Of course, the situation could be also be better than expected and the company did attempt to reassure the market by saying it believes the problems were confined to previous years and that current sales are continuing nicely.

What to do?

What should all of this mean for investors? Well, it’s true that the mere mention of an accounting scandal can oftentimes lead the market to overreact and send shares plummeting for little reason. However, in this case the fact that management doesn’t yet know how much debt it has or how much it will have to restate past profits indicates to me that a wait-and-see approach is best for those on the outside looking in.

This means bargain hunters probably shouldn’t begin a position just yet, even though the company has solid growth prospects and shares are now trading at five times (reported) earnings. That said, contrarian investors may want to reassess this position once interim results and revised past reports are revealed. That’s because providing back end IT services such as cloud storage for mid-market firms is a large growth market with hefty margins and significant recurring revenue. And, even if Redcentric’s net debt is around £30m, it shouldn’t be an unmanageable amount for the highly cash generative company to handle. But, without knowing exactly what the company’s books look like it’s impossible to accurately judge its value. For that reason I would wait for the dust to settle before taking a closer look.