Small-cap investing is a high-risk, high-reward game. Growth stories and rapidly increasing revenues are often quite seductive, but unless you have the highest conviction in the business model on offer, you’d be better off abandoning the company entirely.
With this in mind, I believe Koovs (LSE: KOOV) and LoopUp Group (LSE: LOOP) may be best avoided.
The Indian ASOS?
When a company grows revenue by 151%, as Koovs did last year, I pay attention. It has been described as the “ASOS of India,” but I believe its business model is a far cry from the profitable UK venture.
The company registered £4m in sales in the six months to 30th September 2016. If the business model was sound, you’d expect operating profits to move closer to break-even as revenues explode, but not so at Koovs. The company made a £9.1m loss before tax in the period, which is more than double sales! ASOS’ business model was far more profitable when making similar revenues; in 2002, ASOS lost only £1.7m on revenues of £4.1m and hit break-even with £7m revenues the very next year, while Koovs’ losses keep getting bigger.Â
At last count, Koovs had around £20m in cash, but its operations burned through £12m in the first six months of the year indicating its war chest may not last long. The company could be forced to raise more cash within the next year or so, which could dilute shareholders.
Considering this massive and increasing rate of cash-burn, I believe the £80m market cap is far too high. I still believe Koovs could eventually go bankrupt, or dilute shareholders so much as to render returns sub-par. Therefore, I’ll be avoiding the shares.
LoopUp Group
LoopUp Group offers supposedly innovative conference calls software. A user can quickly organise a meeting by inviting contacts directly from Microsoft Outlook. The program also facilitates easier recording of calls and eliminates the need for dialling in.
There are aspects I like about the company, including impressive momentum in revenue growth and a list of over 1,850 customers that include prestigious firms such as Kleinwort Benson and National Geographic.
Revenues grew 26% to £10.1m last year and the company has just moved into profit. It does capitalise some software development costs, however, which I believe could be flattering results a little by moving some expenses off the income statement and onto the cash-flow statement.Â
For example, the company capitalised £1.74m in developmental costs last year, but amortisation on the income statement came in lower at £1.25m. I don’t believe that tech companies should capitalise software development costs, but in LoopUp’s case I don’t believe this to be a serious problem, although it may be worth keeping this in mind when performing analysis.
The biggest potential problem facing Loopup Group is that its products don’t seem all that unique when compared to competitors. I would not be surprised to see a tech giant launching competing software that blows LoopUp out of the water. Amazon Chime, for example, seems to offer similar and competing services.
LoopUp’s market cap is £59m, which I believe to be too high for a company that is barely break-even and operating in a highly competitive field. If the company gets out-innovated by a tech giant with more firepower, I could personally imagine it ending up virtually worthless.