JDA Software Group Inc (JDAS) is one of November’s Most Dangerous Stocks, small cap special. And like all of our Most Dangerous Stocks the company has (1) misleading earnings = accounting profits are positive and rising while true, economic profits are negative and falling and (2) high valuation = very high expectations embedded in the current valuation. JDAS gets our “Very Dangerous” rating.
Below are the specific Red Flags my research reveals:
- Misleading earnings: JDAS reported a $14.6mm increase in GAAP earnings while our model shows economic earnings declined by $12.9mm (a difference of $27.5mm or 155% of reported net income).
- Very dangerous valuation: stock price of $27 implies JDAS must grow its NOPAT at over 20% compounded annually for 10 years. A 10-year growth appreciation period with a 20%+ compounding growth rate sets expectations for future cash flow performance quite high.
- JDAS competes with industry giants Oracle (ORCL) and SAP (SAP), whose businesses are growing stronger while JDAS appears to be weakening. I doubt a comeback is in the cards for JDAS.
- Free Cash Flow was -$203mm or -15% of the company’s enterprise value last year.
- Asset write-offs of $21mm or 3% of net assets – this means that management has written off at least $0.03 of assets for every $1 on the current balance sheet. Writing off assets is the opposite of creating shareholder value as it reflects management’s inability to derive any profits for the investments it makes with shareholder funds.
- Off-balance sheet debt of $40mm or 6% of net assets.
- Outstanding stock option liability of $13mm or 1% of current market value.
Overall, the risk/reward of investing in JDAS’s stock looks “Very Dangerous” to me. There is lots of downside risk given the misleading earnings and red flags while there is little upside reward given the already-rich expectations embedded in the stock price.
Our report on JDAS has detailed appendices for you to see how we perform all calculations. The primary cause of the difference between economic versus accounting earnings is that JDAS’s NOPAT rose much slower than its invested capital. See Appendix 4 to learn how JDAS’s NOPAT rose more slowly than Net Income. See Appendix 5 for details on JDAS’s invested capital and how off-balance sheet debt and asset write-offs are added back to provide a more accurate reflection of the capital invested in the business. Appendix 7 (in the return on invested capital section) shows how a slight rise in NOPAT margin paired with a big decrease in invested capital turns result in a decrease in return on invested capital (from 6.9% to 4.7%) and economic earnings.
In a business where investors make money by buying stocks with low expectations relative to their future potential, JDAS fits the profile of a great stock to short or sell.
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