Monday, 1 December 2008

Gladstone puts up spirited defence

In Constellation’s attempt to win Gladstone at a knock-down price (25p), I see that Gladstone has come out with a fairly strong defence, based (on the face of it) on a reasonable set of preliminary results for the year to August 2008. Revenue was up 4% at £9.55M, EBITDA before exceptional items and share based payment charge was up £251k to £1.91 million, and operating activities generated £1.25 million of cash (in my mind, cash generation is always a good indicator of strength for a software applications company).

However, the £1.25M seems disappointingly low to me, and the preliminary results show that cash decreased by £400k to £4.6 million “due to development expenditure, purchase of own shares and investment in education business operations” and, more importantly, £521k of development expenditure was capitalised in the year (up from £100k in the year before).

Previous readers of this blog will know my concerns about the capitalisation of software development costs. Software application companies need to continually develop and enhance their products to stay competitive and there is a considerable debate about which development costs should be capitalised, and which costs should be written off as incurred.

The prudent approach of writing off development costs as they are incurred may not be an option if/when the company is trying to repel an unwanted bid (if the £521k of development expenditure had been written off, Gladstone’s EBITDA for the year would have been some £270k less than the previous year – not something that would help the company’s defence).

If, however, the £521k represents (part of) a planned development programme with a business plan showing realistically the returns to be generated from the development, and the development is going to plan, then capitalisation may be a reasonable step. The problem for Constellation is, I suspect, that it doesn’t have access to such information and it can but guess at the validity of the capitalised expenditure.

With only around 10% of acceptances from Gladstone’s other shareholders, although Constellation has extended its bid to 12 December, the bid seems destined to fail at its current level. As previously predicted, I suspect that Constellation will up its bid – if it were to go to 35p, then I believe it would be accepted – anything less is questionable – 30p might succeed, but if they only bid the expected 28p then I suspect it won’t.

No doubt Constellation is going through the results with a fine toothcomb, also trying to get some information on what business is really like for the Gladstone sales and development teams, and sounding out Gladstone’s major investors to see what has to be done to win them over. I suspect that there will be a higher bid, backed up by further arguments from Constellation – I don’t think Constellation, having gone so far, will give up now.

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